Imagine a World Free of Counterparty Risk

A thought-provoking panel discussion at the recent Institute of International Finance meetings in Sydney, held alongside the G20 meetings, left me asking myself a question. The topic of the panel was the impact of regulatory reform on small and medium enterprises and the emerging-market financial sector. After the discussion, I thought, what if the world was free from counterparty risk?

What got me onto this train of thought was the fact that the speakers only gave glancing attention to something that I’ve long considered a truth: developed-market financial regulators really ought to look to their peers in emerging markets for some insights. Much as was the case with the telecomms development in emerging markets, where they largely skipped over landlines and moved directly to mobile phones, so too did capital-market participants skip the development of over-the-counter (OTC) markets and move to highly transparent exchange-traded instruments. In countries where no entity is deemed to be an investment grade credit, counterparty credit risk is avoided at all costs.

So, while market participants watched with great trepidation as new European Market Infrastructure Regulation rules for reporting of OTC trades became effective, regulators in most emerging markets yawned because they’ve had such information since derivatives first entered their markets. This transparency has helped them deal with issues of enormous concern, such as who is buying and selling their currency and what actions should be taken to discourage such activities when they become excessive (at times, Brazil has implemented taxes on trades conducted by foreign investors to slow down the flow of foreign investment), or to attempt to keep domestic capital from leaving the country.

In addition to settling all trades through the central clearinghouse, the exchange also serves an important role by establishing daily prices for all securities, and these must be used in pricing all assets within the market. Many also have buy-in rules, which compel other market participants to settle trades in the event that an entity fails to settle. This then means that rules like those of the Treasury Market Practice Group aren’t necessary because trades all settle on the expected settlement date.

All of these factors first became apparent to me about a decade ago when I was working closely with our investment team in Mumbai. I started asking questions about counterparty risk, only to quickly learn that the central clearinghouse controlled everything. So I then asked the team to consider the solvency of this entity. The question made their heads spin at first. Their immediate response was, of course this entity is solvent and would be protected at all costs. In other words, it was “too big to fail.”

Good or bad, depending on one’s point of view, securities regulators in emerging markets have created a world free of counterparty risk, asset pricing concerns, or opaqueness. Had developed markets had similar structures in place before 2007, perhaps we would now remember a “global growth hiccup” instead of the “global financial crisis”?

The information in this article has been derived from sources believed to be accurate as of February 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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